MONEY MATTERS > More on Money Matters > MM 3
By Paul A. Pouliot
Roth IRA conversion decision deadline approaches
2010 marks the first year that many individuals are able to convert existing IRAs (or workplace savings plans) to a Roth IRA. Income limits that previously prevented individuals or couples with Adjusted Gross Incomes of more than $100,000 from completing a conversion no longer exist. The opportunity is now open to everybody to potentially benefit from tax-free growth of earnings. If you haven’t taken a closer look at a Roth conversion, now might be the time to do so. It could allow you much more flexibility in managing cash flow needs in a more tax-efficient way when you reach retirement.
What’s the appeal?
Perhaps the most attractive feature of a Roth IRA is that earnings grow on a tax-deferred basis and distributions are tax-free. This could be particularly advantageous if you anticipate that your tax bracket will be higher than it currently is by the time you begin withdrawing from the account.
Contributions will be taxed at your current tax rate when you make the conversion, but you will be able to recuperate all of the investment growth you accumulate in the account, tax-free, once holding period requirements are met. (If requirements are not met, taxes and penalties may apply).
The Roth IRA may also be a useful instrument in estate planning. Because income tax is paid on contributions upon conversion, they may be passed onto your beneficiaries income tax-free. (Estate taxes may still apply to Roth IRA assets).
However, while a Roth IRA can provide you with significant tax advantages when the time comes to take distributions, there are current tax consequences when converting. Generally, a conversion to a Roth IRA from your traditional IRA or other eligible retirement plan will be taxable. If your traditional IRA or workplace retirement plan contains after-tax dollars, money is distributed pro rata. Check with your tax advisor to help estimate the actual tax liability that would apply to your conversion.
The coming deadline
Under current law, the ability for anybody to convert regardless of income level is a “permanent” change in the tax law. But a deadline of December 31, 2010 is fast approaching for those making a conversion who want to capture a significant, one-time tax advantage. A conversion completed in this calendar year qualifies for a special deferral of payment of the tax due as a result of the conversion.
You can choose to claim the income from the conversion on your 2010 tax return. Alternatively, you can claim half of the income generated by the conversion on your 2011 tax return (in 2012), and the other half on your 2012 tax return (filed in 2013). This not only allows you to delay tax payments, but by spreading out the impact on your total income, may create the potential to retain a lower tax bracket in both of those years, reducing your overall tax liability.
The actual tax you pay could be subject to many variables, including potential changes to tax rates in future years and the possibility that other forms of income may increase significantly in 2011 and 2012, pushing you into a higher tax bracket for purposes of calculating your Roth conversion tax liability.
Future tax risks
Some are concerned that the government’s desire to find new sources of tax revenue to offset current debt and future demands on programs will result in changes in tax policy. Could this mean that Congress will require that Roth IRA distributions lose their tax-free status? Nobody can predict for certain what would happen. It is just as possible that Congress could decide to alter the rate of taxation levied on distributions from traditional IRAs or workplace savings plans (such as 401(k)s). In other words, making decisions today about your financial future can’t be based on sheer speculation. You have to use the best available information that exists today. That means your interests will be best served by working with the tax laws as they are currently defined rather than trying to predict future actions of Congress.
Paying for the conversion
A key hurdle to making the decision to convert is the tax issue. You must come up with money to cover the tax liability. The conversion is most likely to work to your long-term benefit if the tax bill can be paid utilizing dollars available in existing taxable accounts. This allows you to maximize the tax advantages of your Roth IRA by keeping your retirement savings invested.
Here is a way to justify a Roth conversion in today’s market. An extended period of market volatility has resulted in a number of investors keeping money on the sidelines in cash-equivalent investments. Rather than wait to reinvest these dollars in the market at a later date, consider using those funds today to pay the tax on a Roth IRA conversion. This has the effect of investing that money today in return for tax-free withdrawals from a portion of your savings in retirement.
One more reason to convert before the end of the year – if you change your mind before October 15, 2011, you can “recharacterize” your Roth IRA, returning the money to a traditional IRA and avoiding the tax consequences of conversion. This opportunity for a “do-over” reduces the risks involved with giving a Roth conversion a try this year.
Paul A. Pouliot CFP®, CHFC®, CASL®
Senior Financial Advisor, An Ameriprise Platinum Financial ServicesSM practice, Ameriprise Financial Services, Inc. – 116 South River Road | Bedford, NH 03110 – Office: 603.296.0030 | Fax: 603.296.0028 / firstname.lastname@example.org - www.ameripriseadvisors.com/paul.a.pouliot
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